Few Basic Strategies for Derivative Trading

Have a view on the market?

Example A.
On 01 March an investor feels the market will rise
– Buys 1 contract of March ABC Ltd. Futures at Rs. 260
(market lot : 300)
09 March
– ABC Ltd. Futures price has risen to Rs. 280
– Sells off the position at Rs. 280. Makes a profit of
Rs.6000 (300*20)
Example B.
On 01 March an investor feels the market will fall
– Sells 1 contract of March ABC Ltd. Futures at Rs. 260
(market lot : 300)
09 March
– ABC Ltd. Futures price has fallen to Rs. 240
– Squares off the position at Rs. 240
– Makes a profit of Rs.6000 (300*20)
Example C.
Assumption: Bullish on the market over the short
term Possible Action by you: Buy Nifty calls
Example:
Current Nifty is 3880. You buy one contract (lot size 50) of Nifty near month calls for Rs.20 each. The strike price is 3900. The premium paid by you : (Rs.20 * 50) Rs.1000. Given these, your break-even Nifty level is 3920 (3900+20). If at expiration Nifty advances to 3974, then
Nifty expiration level 3974
Less Strike Price 3900
Option value 74.00 (3974-3900)
Less Purchase price 20.00
Profit per Nifty 54.00
Profit on the contract Rs. 2,700 (Rs. 54* 50)
Note:
1) If Nifty is at or below 3900 at expiration, the call holder would not find it profitable to exercise the option and would loose the premium, i.e. Rs.1000. If at expiration, Nifty is between 3900 (the
strike price) and 3920 (breakeven), the holder could exercise the calls and receive the amount by which the index level exceeds the strike price. This would offset some of the cost (premium).
2) The holder, depending on the market condition and his perception, may sell the call even before expiry.
Example D.
Assumption: Bearish on the market over the short term Possible Action by you: Buy Nifty puts
Example:
Current Nifty is 3880. You buy one contract (lot size 50) of Nifty near month puts for Rs.17 each. The strike price is 3840. The premium paid by you will be Rs.850 (17*50). Given these, your breakeven Nifty level is 3823 (i.e. strike price less the premium). If at expiration Nifty declines to 3786, then

Put Strike Price 3840
Nifty expiration level 3786
Option value 54 (3840-3786)
Less Purchase price 17
Profit per Nifty 37
Profit on the contract Rs.1850 (Rs.37* 50)
Note:
1) If Nifty is at or above the strike price 3840 at expiration, the put holder would not find it profitable to exercise the option and would loose the premium, i.e. Rs.850. If at expiration, Nifty is between 3840 (the strike price) and 3823 (breakeven), the holder could exercise the puts and receive the amount by which the strike price exceeds the index level. This would offset some of the cost (premium).
3) The holder, depending on the market condition and his perception, may sell the put even before expiry.
Example E.
Use Put as a portfolio Hedge?
Assumption: You are concerned about a downturn in the short term in the market and its effect on your portfolio. The portfolio has performed well and you expect it to continue to appreciate over the long term but would like to protect existing profits or prevent further losses. Possible Action: Buy Nifty puts.
Example:
You hold a portfolio of 5000 shares of ABC Ltd. Ltd. valued at Rs. 10 Lakhs (@ Rs.200 each share). Beta of ABC Ltd. is 1. Current Nifty is at 4250. You wish to protect your portfolio from a drop of more than 10% in value (i.e. Rs. 9,00,000). Nifty near month puts of strike price 3825 (10% away from 4250 index value) is trading at Rs. 2. To hedge, you buy 5 puts, i.e. 250 Nifties, equivalent to Rs.10 lakhs*1 (Beta of ABC Ltd) /4250 or Rs. 1130000/4250. The premium paid by you is Rs.500, (i.e.250 * 2). If at expiration Nifty declines to 3500, and ABC Ltd. falls to Rs.164.70, then

Put Strike Price 3825
Nifty expiration level 3500
Option value (per Nifty) 325 (3825-3500)
Less Purchase price (per Nifty) 2
Profit per Nifty 323
Profit on the contract Rs.80,750 (Rs.323* 250)
ABC Ltd. shares value Rs.8,23,500
Profit on the Nity put contracts Rs.80,750
Total value Rs.9,04,250

Rs. 9,04,250 is approx. 10% lower than the original value of the portfolio. Without hedging using puts the investor would have lost more than 10% of the value.

Popularity: 5% [?]

Related posts:

1. Derivative Trading II
2. Derivative Trading III
3. Derivatives Trading I
4. How is a Mutual Fund Setup?
5. Mutual Fund Terms

Tags: Break Even, Bullish, Derivative, Examples, Have a view on the Market?, Hedging, Investor, Nifty, Portfolio, Premium, Shares, Strategies, Strike Price, Trading, Use put as a Portfolio Hedge?